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1. 11 Measuring the Cost of Living

2. The Cost of Living • We need all sorts of things to live • These things are typically not free • So, what’s the cost of living the way we actually live? That is, what’s the cost of buying the things we buy?

3. Why Do We Need to Know the Cost of Living? • To see whether our incomes are keeping up with the cost of living

4. The Consumer Price Index • The Consumer Price Index (CPI) is a measure of the overall cost of the goods and services bought by a typical consumer. • When the CPI rises, the typical family has to spend more dollars to maintain the same standard of living. • The Bureau of Labor Statistics (BLS) reports the CPI each month. • It is used to monitor changes in the cost of living over time.

5. http://research.stlouisfed.org/fred2/series/CPIAUCSL CHAPTER 24 MEASURING THE COST OF LIVING

6. How the CPI Is Calculated [BLS] • Fix the basket: figure out what’s in the “basket” of goods that the typical consumer buys • Find the prices paid by the typical consumer for the goods in the “basket” • Compute the basket’s cost • Choose a base year and compute the CPI for all years • Compute the inflation rates for all years

7. How the Consumer Price Index Is Calculated • Fix the basket: determine what “basket” of goods the typical consumer buys. • The Bureau of Labor Statistics (BLS) identifies a market basket of goods and services the typical consumer buys. • The BLS conducts monthly consumer surveys to set the weights for the prices of those goods and services.

8. 17% Transportation 15% 42% Food and beverages Housing Education and 6% communication 6% 6% 4% 4% Medical care Other goods Recreation Apparel and services FYI: What Is in the CPI’s Basket? [BLS]

9. How the Consumer Price Index Is Calculated • Find the Prices: Find the prices of each of the goods and services in the basket for each point in time.

10. How the Consumer Price Index Is Calculated • Compute the Basket’s Cost: Use the data on prices to calculate the cost of the basket of goods and services in different years.

11. How the Consumer Price Index Is Calculated • Choose a Base Year and Compute the Index: • Designate one year as the base year, making it the benchmark against which other years are compared. • Compute the index by dividing the price of the basket in one year by the price in the base year and multiplying by 100.

12. How the Consumer Price Index Is Calculated • Compute the inflation rate: The inflation rate is the percentage change in the price index from the preceding period.

13. How the Consumer Price Index Is Calculated • The Inflation Rate • The inflation rate is calculated as follows:

14. http://research.stlouisfed.org/fred2/series/CPIAUCSL CHAPTER 24 MEASURING THE COST OF LIVING

15. How the Consumer Price Index Is Calculated: Another Example • Base Year is 2002 • Basket of goods in 2002 costs \$1,200 • The same basket in 2004 costs \$1,236 • CPI for 2004 = (\$1,236/\$1,200)  100 = 103 • Prices increased 3 percent between 2002 and 2004

16. Problems in Measuring the Cost of Living • The CPI is an accurate measure of the selected goods that make up the typical bundle, but it is not a perfect measure of the cost of living.

17. Problems in Measuring the Cost of Living • Substitution bias • Introduction of new goods • Unmeasured quality changes

18. Problems in Measuring the Cost of Living: Substitution Bias • The basket does not change to reflect consumer reaction to changes in relative prices. • Consumers substitute toward goods that have become relatively less expensive. • The index overstates the increase in cost of living by not considering consumer substitution.

19. Substitution Bias in CPI • Suppose Red Apples and Green Apples are the only two commodities and are identical in taste. • Suppose the typical consumer’s basket has, for many years, contained 10 of each type. • Suppose the prices in 2005 (the base year) were \$2 per apple for both types. So, the cost of the consumer’s basket was \$40 in 2005. • Suppose the prices in 2006 are \$4 for a Red Apple and \$2 for a Green Apple. So, the cost of the consumer’s basket is \$60 in 2006. • Therefore, the CPI for 2006 is (60/40) × 100 = 150, indicating a 50% increase in the cost of living • But has the cost of living really increased? • No. The consumer can switch to zero Red Apples and 20 Green Apples and enjoy the same satisfaction as always without any increase in cost. • Therefore, the CPI exaggerates the true cost of living.

20. Problems in Measuring the Cost of Living: Introduction of New Goods • The basket does not reflect the change in purchasing power brought on by the introduction of new products. • New products result in greater variety, which in turn makes each dollar more valuable. • Consumers need fewer dollars to maintain any given standard of living.

21. Problems in Measuring the Cost of Living: Unmeasured Quality Changes • If the quality of a good rises from one year to the next, the value of a dollar rises, even if the price of the good stays the same. • If the quality of a good falls from one year to the next, the value of a dollar falls, even if the price of the good stays the same. • The BLS tries to adjust the price for constant quality, but such differences are hard to measure.

22. Problems in Measuring the Cost of Living • The substitution bias, introduction of new goods, and unmeasured quality changes cause the CPI to overstate the true cost of living. • The issue is important because many government programs use the CPI to adjust for changes in the overall level of prices. • The CPI overstates inflation by about 1 percentage point per year.

23. The GDP Deflator Versus the Consumer Price Index • The GDP deflator is calculated as follows:

24. The GDP Deflator Versus the Consumer Price Index • The BLS calculates other prices indexes: • The index for different regions within the country. • The producer price index, which measures the cost of a basket of goods and services bought by firms rather than consumers. [BLS]

25. The GDP Deflator Versus the Consumer Price Index • Economists and policymakers monitor both the GDP deflator and the consumer price index to gauge how quickly prices are rising. • There are two important differences between the indexes that can cause them to diverge.

26. The GDP Deflator Versus the Consumer Price Index • The GDP deflator reflects the prices of all final goods and services produced domestically, whereas... • …the consumer price index reflects the prices of all final goods and services bought by consumers.

27. The GDP Deflator Versus the Consumer Price Index • The Consumer Price Index compares the price of a fixed basket of goods and services to the price of the basket in the base year (only occasionally does the BLS change the basket)... • …whereas the GDP deflator compares the price of currently produced goods and services to the price of the same goods and services in the base year.

28. CPI GDP deflator Figure 2 Two Measures of Inflation Percent per Year 15 10 5 0 1965 1970 1975 1980 1985 1990 1995 2000

29. Correcting Economic Variables For The Effects Of Inflation • Price indexes are used to correct for the effects of inflation when comparing dollar figures from different eras. • See the BLS’s inflation calculator

30. Dollar Figures From Different Times • Do the following to convert (inflate) Babe Ruth’s wages in 1931 to dollars in 2001:

31. Dollar Figures From Different Times

32. Indexation • When some dollar amount is automatically corrected for inflation by law or contract, the amount is said to be indexed for inflation.

33. Real and Nominal Interest Rates • Interest represents a payment in the future for a receipt of money in the past.

34. Real and Nominal Interest Rates • The nominal interest rate is the interest rate usually mentioned in borrowing or lending contracts. • It is not corrected for inflation. • It is the interest rate that a bank pays. • The real interest rate is the interest rate that is corrected for the effects of inflation.

35. Real and Nominal Interest Rates • You borrowed \$1,000 for one year • Nominal interest rate was 15% • During the year, inflation was 10% Real interest rate = Nominal interest rate – Inflation =15% - 10% = 5%

36. Figure 3 Real and Nominal Interest Rates Interest Rates (percent per year) 15% Nominal interest rate (3-month Treasury Bills) 10 5 0 Real interest rate 5 1965 1970 1975 1980 1985 1990 1995 2000 2005

37. Summary • The consumer price index shows the cost of a basket of goods and services relative to the cost of the same basket in the base year. • The index is used to measure the overall level of prices in the economy. • The percentage change in the CPI measures the inflation rate.

38. Summary • The consumer price index is an imperfect measure of the cost of living for the following three reasons: substitution bias, the introduction of new goods, and unmeasured changes in quality. • Because of measurement problems, the CPI overstates annual inflation by about 1 percentage point.

39. Summary • The GDP deflator differs from the CPI because it includes goods and services produced rather than goods and services consumed. • In addition, the CPI uses a fixed basket of goods, while the GDP deflator automatically changes the group of goods and services over time as the composition of GDP changes.

40. Summary • Dollar figures from different points in time do not represent a valid comparison of purchasing power. • Various laws and private contracts use price indexes to correct for the effects of inflation. • The real interest rate equals the nominal interest rate minus the rate of inflation.